2012 H2 A Level CSQ1_The Market for Cotton

(a) (i) Why might the changes shown in Table 1 have led to an increase in the world price of cotton? [1]

World production of cotton has fallen from 2008/09 to 2009/10 while world consumption of cotton has
increased from 2008/09 to 2009/10; the shortage led to an increase in the world price of cotton.

Or

The shortage of cotton grew by 5.7 times from 2008/9 to 2009/10, hence leading to the increase in world
price of cotton.

Note: Candidates need to refer to specific changes in world production and consumption, mentioning
demand was greater than supply is insufficient.

(ii) Given the information contained in Table 1, identify the country that has had the greatest impact
on world prices. Justify your answer. [3]

China has had the greatest impact on world prices.

China is the largest producer and consumer of cotton from 2008 to 2010.

When China’s production of cotton fell the most from 2008/09 to 2009/10 by 12.8%, the world supply of
cotton was significantly lowered, which hence impacted world prices the most. In addition to that,
consumption of cotton in China increased the most by 10.2%.

[Identify the country ; Comparisons made between country output levels; Cite evidence]

(b) What can you conclude from the evidence in Extract 1 about the price elasticity of supply of cotton
in Brazil? [2]

Supply of cotton in Brazil is relatively price inelastic (i.e. PES < 1), as time is required to grow and
harvest the cotton crops. Even with the increase in world price of cotton by 73% in the previous year (ext
1), quantity of cotton in Brazil is projected to increase less than proportionately, by only 32.5% and will
occur only in the next season.

Note: Candidates should not be using factors that affect supply to justify. E.g. a common mistake was to
attribute to shifts in supply as a result of poor harvest.

(c) Explain the likely reason why the Brazilian government eliminated the 10% tariff on cotton imports
and the Indian government restricted cotton exports. [3]

[1m to identify that prices will decrease]

The actions above would have led to lowered cotton prices for both countries.

[1m to explain linkage with case evidence for either country; diagram not required]
For instance, with the ease of tariffs, foreign imported cotton will be relatively cheaper in Brazil and hence,
greater quantity of imported cotton can be consumed. This can help to ease the shortage of cotton in its
domestic market due to the ‘four-month drought’ (ext 1).

Or

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 The Indian government has restricted the sale of cotton due to the increasing domestic consumption of
cotton from 2008 to 2010(table 1). By restricting cotton exports, it would help to increase quantity
supplied of cotton and hence, lower the price of cotton for Indian consumers.

[explain benefits to the different parties]

The lowered cotton prices will benefit its textile manufacturers in terms of lowered unit cost of production
and hence lead to higher profits, ceteris paribus. (or cost savings could be passed down onto consumers in
the form of lowered prices for cotton products.)

(d) In Extract 2 the chief executive of Next considers the effect of an 8% rise in the price of Next’s
clothes. With reference to the concept of price elasticity of demand, explain the expected impact of
this price rise on the firm’s total revenue. [3]

Extract 2 mentions that an 8% rise in the price of Next’s clothes will lead to a fall in the volume of sales by
10%. This means that the demand for Next’s clothes is relatively price elastic (PED>1 ~ 1.25). [1m with
case evidence] Therefore, given an increase in price of Next’s clothes from P0 to P1, there will be a more
than proportionate fall in the quantity demanded from Q0 to Q1. [1m] As a result, when price rises, the
firm’s total revenue would fall as the fall in revenue due to a fall in quantity demanded(area A) would
outweigh the rise in revenue due to an increase in price of Next’s clothes(area B). [ explain changes in total
revenue with respect to diagram provided]

(e) With reference to the data where appropriate, discuss the view that supply factors are likely to be
more important than demand factors in explaining changes in the price of cotton. [8]

Identify all demand factors

From Extract 2, when retail sales picked up after the financial crisis, demand for cotton rose. This is due to
the recovery in income levels. Assuming clothing is a normal good, demand for clothing will also increase.
This will have led to an increase in derived demand for cotton by the clothing companies as cotton is a
factor of production for clothing. Hence, contributing to the increase in the price of cotton.

Identify and explain at least 1 supply factor

From Extract 1 and 2, the Indian government’s restriction of exports suggests a fall in world supply of
cotton, especially since India is the world’s second biggest exporter after the United States. In addition, a
“four-month drought” in Brazil, which is the world’s fifth largest exporter of cotton, will lead to poor cotton
harvest and hence, decreasing supply of cotton.
OR
Another supply factor is seen in Extract 2, which says that the increase in the price of cotton could be
caused by the financial crisis in 2008, which caused farmers to switch to planting “higher-value crops such
as corn and soya”. Given that production of corn, soya and cotton are in competitive supply, production of
corn and soya will lead to a diversion of resources e.g. land away from cotton production. As a result, this
will result in a fall in supply of cotton. [alternatively, the fall in the number of cotton growers led to a fall
in supply of cotton.]

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 OR
With “major cotton-producing regions such as China and Pakistan were suffering devastating floods”, the
destruction of land for the purposes of growing cotton therefore led to a fall in the supply of cotton.
All the above factors mentioned would have caused a significant fall in supply of cotton in the world.

Thesis: Supply factors are likely to be more important than demand factors
The fall in supply and the increase in demand will together contribute to the increase in the world price of
cotton. A shortage of Q2Q4 is created at the existing price level, P1. This leads to an upward pressure on
price, causing quantity demanded to fall and quantity supplied to increase. A new equilibrium is reached
when the shortage is eliminated at price P2. However, the extent of shift in supply is likely to be much
greater as analysed above and therefore had a greater impact on the price of cotton, as seen in the Figure
below.

[Evaluation] Also, the extent of shift in demand for cotton may not be as substantial and is dependent on
namely the income elasticity of demand for clothing. Since clothes are likely to be regarded as necessity
goods, the demand for clothing will increase less than proportionally with any increase in income level.
Therefore, this may not have triggered a substantial rise in derived demand for cotton by the clothing
companies.

Furthermore, the demand for cotton is likely to be price inelastic as cotton is considered a necessity for
the production of clothing. Given the changes in supply, the price of cotton would rise much greater (from
P1 to P3).

Anti-Thesis: Demand factors are likely to be more important than supply factors
On the other hand, it could be that demand factors are more important in explaining changes in the price of
cotton. From Table 1, world consumption (demand) increased by 6.64% while world production (supply) fell
by 5.51%. The overall increase in demand was greater than the fall in supply and therefore the demand
change may have had a greater impact on the price of cotton.
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 In addition, as mentioned earlier in (b), supply of cotton is relatively price inelastic. Hence, with the increase
in demand from DD1 to DD2, it will lead to a greater increase in price from P2 to P3.

Synthesis/ Conclusion
Overall, supply factors are likely to be more important in this scenario due to the various changes in
supply of cotton produced by the individual cotton-producing countries that affected overall world supply.
Also, supply factors are more significant given that supply of cotton is relatively price inelastic, resulting in
higher cotton prices given any changes in demand.

However, an important point to note is that there are also insufficient materials to draw fully on the factors
affecting demand such as changes in prices of related raw materials markets, extent of income changes
and impact on demand for clothing etc.

Note: Candidates need to explain evidences of supply and demand changes with appropriate analytical
tools. Candidates also need to explicitly explain the importance of price elasticity of demand and supply
and in conclusion, rank these factors.

(f) Using the evidence in the data, discuss how the market structure of the retail clothing industry in
the UK will affect the ability of firms in this industry to make excess profits in the long run when
faced with an increase in the price of cotton.[10]

Interpret the question

In this question, we have to analyse how the increase in the price of cotton will affect the firms given its
characteristics, if any, and hence its competitive behavior in determining the level of profits that they are
able to make in the long run.

Identify the market structure of the retail clothing industry: Monopolistic competitive
The retail clothing firms exist in a monopolistic competitive industry as they face strong competition from
‘thousand of stores”(ext 3). Each firm offers a differentiated product as seen from the example of
Primark(ext 2) where it is well-known for emulating designer looks at rock-bottom prices. There is also low
barriers to entry and exit as new firms could enter easily as stated in extract 3 where a few international
brands entered the UK market a few years ago. Local firms such as Asda was also said to have exited the
industry when it could not make sufficient profit.

As seen in the figure below, given the strong competition within the industry, each firm faces a relatively
price elastic demand curve, AR1.

Interpret trigger given: increase in the price of cotton

With “60% of the cost of clothing in the fabric”(ext 2) significant increase in the cost of producing clothing

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 Retail clothing firms will then face higher cost of buying manufactured clothes from those manufacturing
firms who faced high unit COP (due to the increase cotton prices) hence, this will bring about an
increase in both MC and AC of production.

Assume that firms are initially making normal profits in the short run. With the increase in MC from MC1 to
MC2, this will result in a new profit-maximising equilibrium(MC= MR) to be fixed at Q2 instead, resulting in a
higher equilibrium price at P2 instead of P1. This highly correlates to findings in extract 2 where it is
mentioned that given that prices of clothing are fundamentally low, when “costs rise, they have to be
passed onto consumers”.

Impact on different firms in the industry

Clothing firms which are not able to reduce the cost may incur subnormal profits(shaded area) and hence
be forced to exit the industry given the low barriers to entry.

On the other hand, clothing firms that are able to product differentiate successfully to suit its target
audience maybe able to earn some supernormal profits. As mentioned in extract 3 that if “Tesco could get
the look and feel right in a dedicated clothing store, then it could be a good way of building brand
awareness”. A negative example is the case of Asda which failed and closed down its high street clothing
shops after four and a half year trial(ext 3) after switching from selling clothes in its supermarkets. Building
greater brand awareness will enable the retail clothing firms to make its products less substitutable to its
rivals’, making the demand for its clothing less price elastic. This is essential for a competitive market as
seen in extract 2 where an increase in price of Next’s clothes will cause its sales to fall by 10%, hence
reducing its total revenue. By making its demand less price elastic, firms will be more able to maintain its
revenue level despite any price increments.

[Evaluate] The extent to which the firms can retain its supernormal profits in the long run is also dependent
on the severity of the cotton shortage. Given that cotton shortage has persisted for 3 years from 2008 to
2010 (table 1) and is worsening, coupled with a weaker pound(ext 2), UK retail firms may indeed face
higher cotton prices in the long run. Therefore, firms will need to further product differentiate to
maintain/increase its total revenue.

[Evaluate]
The extent to which cost of production increases can be very substantial. Retail clothing firms are likely to
be facing increases in costs of production due to other sources. E.g. ext 2 mentions other sources of costs
including ‘increased labour costs’, ‘rising freight costs’ and ‘unfavourable foreign exchange movements’.

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 Synthesis and conclusion
Firms in this clothing industry that are earning excess profits initially are unlikely to maintain them in the
long run as it will likely attract new firms in joining the industry given the low barriers to entry and exit. New
firms will enter and hence, erode away some of the market share of the existing firms, hence decreasing
average and marginal revenue (from AR1,MR1 to AR2, MR2). New profit-maximising eqm is at Q2 where
the new eqm price is at P2. At this price, average cost of producing Q2 equals to the price charged, hence,
firms will end up making normal profits in the long run.

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